Evaluation support summary

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1 User5 SMALL Page FIRM 1LOAN 10/01/01 GUARANTEE Loan SCHEME GuaranteeScheme (SFLGS) (SFLGS) Executive EXECUTIVE Summary SUMMARY 1.1 Introduction The (SFLGS) was introduced by the Department of Trade and Industry (DTI) in 1981 to address a gap in the market for small firms access to finance. The Scheme provides a guarantee to encourage banks and other financial institutions to lend where small firms are unable to raise conventional finance for viable projects because of a lack of security or established track record. Since its introduction, the Scheme has undergone three value-for-money evaluations, the last evaluation in 1991 covering lending up to The DTI now requires a further full evaluation, particularly to study the effects of changes introduced in At this time the Scheme was focused more closely on established businesses, and support for local service businesses, notably retail and subsequently catering were severely curtailed. The evaluation has also sought to inform the DTI s wider Review of Finance for SMEs. The objective of the evaluation is to test the continuing validity of the rationale and to measure the benefits that the Scheme has delivered and hence to establish whether the Scheme represents value-for-money for public expenditure. The central aim of the evaluation is to assess to what extent the Scheme has promoted finance to small firms that would not have otherwise received it. 1.2 Methodology The evaluation has used a number of methods of investigation: review of the small firm financing literature and interviews with experts in the field; econometric analysis of the SFLGS database, providing data on over 60,000 loans; large scale telephone surveys of 449 borrowers and 148 lenders branches; and interviews with 50 borrowers, 17 lenders SFLGS units and 15 lenders branches. 1.3 Rationale and objectives of SFLGS Small businesses make a significant contribution to employment and income in the UK which continues to increase over time. However, they are not just scaleddown versions of larger businesses and their financing has several unique features. An issue of particular concern has been that banks base their loan assessment primarily on collateral rather than future business prospects. As small firms often lack this collateral the potential for a market failure exists.

2 The problem of availability of funds has long been recognised by policy makers. The Wilson Committee (1979) recommended that there was a need for a scheme to aid the provision of finance to small businesses under two conditions: if sufficient funds were not available on reasonable terms; and/or if the public return from activities of small firms were greater than the private benefit; e.g. job creation. In addition to the SFLGS primary objective of addressing a financial market failure faced by small firms, evaluations have also examined the extent of wealth and employment creation as well as the impact on lender behaviour. Since the Scheme started in 1981, six main phases can be identified. Table 1.1 shows the main parameter changes that have occurred over these phases which have been accompanied on occasion by changes in eligibility. Table 1.1. Evolution of the SFLGS Phas e Duration Guarantee (percent) Premium (percent) Bank Loan Spread on Small Business Loans I 6/81 to 5/ II 6/84 to 12/ III 1/85 to 3/ IV 4/86 to 3/ V 4/89 to 6/ VI Notes: 7/93 to present 70 or or The 70 percent guarantee in phase VI is applicable to firms trading less than two years and the 85 percent guarantee to established firms who were trading more than 2 years before application. 2. The 1.5 percent premium in phase VI is applicable to firms taking a variable rate of interest and the 0.5 percent premium to firms who take a fixed rate of interest. 3. The premium was charged on the guaranteed amount in phases I-V, but is based on the whole amount in phase VI. Source. KPMG The current phase of the SFLGS, phase VI, is the subject of this evaluation. The Scheme underwent a number of changes at the start of phase VI, most notably: the introduction of an 85 percent guarantee for established firms (over 2 years trading); the application of the premium to the whole amount of the loan, rather than the guaranteed amount only ;

3 the introduction of a different premium for fixed interest rates (0.5 percent) and variable rates (1.5 percent); the removal of retail three months before the start of phase VI, and catering in 1996, from the list of eligible industrial sectors; and the removal in 1996 of the inner city 85 percent guarantee. 1.4 Evaluation findings The SFLGS market Existing academic studies suggest that the market for small firm finance may be segmented in a number of different ways. In examining the SFLGS and its role in small firm finance support it is useful to consider the overall market segments and the segments that form the core of the SFLGS market under Phase VI. Analysis of the literature and interviews with experts in the field suggests that the segments that report most difficulty in gaining access to finance are shaded in table 1.2 below. Table 1.2. Small firm finance gap by market segmentation Phase of developme nt Sector Technology Employmen t Turnover Security Seed Start- up Growth (slow) Growth (fast) Manufactur ing Constructio n Low technology Single selfemployed (0-1) 0.2m Unsecur ed Mature Micro (1-9 ) 0.2-2m Secured Retail Innovating Small (10-49) Other services High Technology Buy in/buy out Note. This table should not be read across Source. KPMG Medium(50-200) Over 2 million Partial security Based on an analysis of the SFLGS database and the borrowers survey, table 1.3 shows the types of firms supported by the SFLGS in phase VI.

4 Table 1.3. UK SFLGS market segmentation Phase of development Sector Technology Employment Turnover Security Seed Manufacturing Low technology Single self employed (0-1) 0.2m Start- up Construction Mature Micro (1-9) 0.2-2m Growth Retail Innovating Small (10-49) Over 2 million orientated Other services High Technology Buy in/buy out Note. This table should not be read across Source. KPMG Medium (50-200) Unsecured Secured Partial security Table 1.3 suggests that the SFLGS is reaching many of the segments that face financing difficulties, but also highlights the segments that do not draw on it. This includes the very low end of the employment size band and the higher risk ventures, such as seed and higher technology firms. However, our analysis of international loan guarantee schemes show that they also tend not to cover the single self-employed (SSE) or seed/high technology firms. This suggests that these segments require other financial instruments to be employed and that loan guarantee schemes may not be appropriate. The take-up of loans under the SFLGS in phase VI of the Scheme differs from previous phases, as demonstrated by figure 1.1. In particular, the increase is almost entirely composed of established firms. Analysis suggests that the increase in loans to these firms was encouraged by the increase in the guarantee provided to these firms to 85 percent. The level of start-up loans has been at a similar level to the previous phases.

5 Figure 1.1: Drawdowns by start-up and non-start-up Drawdowns(StartUps) 400 Drawdowns(NonStartUps) Monthly Drawdowns Source. KPMG analysis of the SFLGS database Of these firms, 86 percent in our survey reported that they are growth orientated. This suggests that in phase VI the SFLGS appealed to firms who were more growth orientated than the general SME population. Typically, these firms draw down loans of less than 100,000 with an average of 40,000, employ around 10 employees and on average grow their employment base by 50 percent in the 18 months after receipt of the loan Lenders use of the SFLGS Analysis of the data indicates there is no close relationship between the lenders share of the small business market and the number of SFLGS loans they make. To examine this further the incentives for lenders to take part in the Scheme were considered. Investigation revealed that the total net revenue made by all lenders from the Scheme has been between 2-3 million per quarter in phase VI. This excludes any administration costs and represents a step change from previous phases of the Scheme, where far lower and sometimes negative returns were made by lenders. Analysis of the determinants of the margins charged by lenders demonstrated that : lenders are charging different margins after allowing for other factors; and that margins charged by lenders do not move proportionately in line with base rates (meeting an accepted test for credit rationing).

6 1.4.3 Defaults Payments of the guarantee to lenders following the default of a loan is the main cost of the Scheme for Government. To consider how this cost might be reduced, the evaluation looked at the factors influencing defaults. The main findings were that: the probability of default varied across lenders; the probability of start-ups and existing firms (0-2 years since inception) defaulting was higher than the probability of established firms defaulting; firms using the loan capital for working capital were more likely to default; partnerships were less likely to default than sole traders, with limited companies being the most likely to default; strong industry effects exist, unlike previous phases, with the manufacturing sector most likely to default; the use of advisory support (via a pilot scheme that linked advice with the loan) in combination with the loan reduces the probability of default; and the duration structure of defaults in phase VI was remarkably similar across different ages of firms and similar to that of previous phases Validity of the Scheme Continuing rationale Since the last evaluation of the Scheme there have been changes in the way in which banks relate to the small business sector and it is apparent there is greater competition in the market for small firm business. The quality of information on small firms has improved with credit rating systems having developed further to enable banks to deal with the risks presented by smaller firms. The way in which banks manage relationships has improved to the benefit of the small firms sector. The market changes have led to recognisable improvements in the funding for smaller enterprises generally, albeit in a better macro economic climate. Despite these favourable trends it is clear from survey evidence that firms on the Scheme face margins that do not move proportionately in line with base rates (meeting an accepted test for credit rationing) and the continued need for security backed lending. Some 71 percent of the survey sample stated that lack of security and 20 percent a lack of track record, were the reasons for using the SFLGS. This accords with the findings from surveys by representative bodies and independent analysis that collateral is required for the majority of lending by banks, and that track records of less than four years count for very little. Therefore there is evidence, based on the responses from SFLGS applicants and discussions with lenders and intermediary bodies, that small firms which lack collateral or a track record continue to face problems in obtaining finance and hence there is a continuing justification for the existence of a Scheme aimed at this issue. A related aim of the SFLGS is to change lender behaviour over time so loans to SMEs are based on business prospects, rather than the availability of security. If

7 successful this would alleviate the market failure. However, interviews with lenders and experts in the area have provided no evidence that such a change in behaviour has occurred. This is consistent with the findings of previous evaluations Finance additionality The survey findings show that around 70 percent by number of firms, or around 60 percent of the total value of loans, were finance additional in phase VI. This level of additionality is broadly similar to that found in previous evaluations. The SFLGS also plays an important role in leveraging funds in phase VI of the Scheme. Some 28 percent of SFLGS loans were part of a financial package, raising a total of 161 million of additional private sector finance. Of this finance, 50 million was contingent on the provision of the SFLGS loan Economic impact Firms supported under SFLGS may displace other firms in the national economy. Survey results indicate that national displacement is in the range of 76 percent to 86 percent. Phase VI displacement rates are similar to those found in previous evaluations. However, displacement does not capture supply side aspects that impact on the competitiveness of the firms assisted. Survey data suggested that 53 percent of firms were using the SFLGS finance to develop a new product or service, 64 percent to open up a new market, 25 percent to develop a new process and 32 percent to introduce a sector leading edge technology. This evidence suggests that firms are engaged in activities which could provide a wider economic benefit. In relation to the objective of growth the Scheme also appears to be performing well. Some 86 percent of firms stated they were growth rather than lifestyle oriented. Table 1.4. SFLGS employment impact in 18 months following loan Impact Stage Employment Total employment in all SFLGS assisted firms 144,400 Total employment in all surviving SFLGS assisted firms (created and safeguarded) Total employment in all surviving finance additional SFLGS firms (created and safeguarded). Total employment in all surviving finance additional SFLGS assisted firms less allowance for national displacement Net cost-per-job of all surviving finance additional SFLGS assisted firms after allowance for national displacement Source. KPMG analysis 132,300 39,700 5,400 to 9,500 9,500 to 16,600

8 Table 1.4 summarises the main employment impacts of SFLGS in phase VI. The amount of additional employment (created and safeguarded) that may be directly attributed to the SFLGS is on average 2.4 jobs per firm in the 18 months following the loan. However, after allowing for national displacement at 86 and 76 percent the number of additional jobs falls to between 0.3 and 0.6 jobs per firm. Summing these effects to represent the population of finance additional loans in phase VI results in between 5,400 and 9,500 net additional jobs created in the 18 months following the loan. A similar calculation for net additional sales turnover gave a net additional increase in sales turnover per firm of between 16,000 and 29,500 in the eighteen months following the loan. The results presented in this section are broadly similar to those found in previous evaluations of the SFLGS Cost-effectiveness The evaluation has measured the cost effectiveness of the Scheme in terms of net cost per job created. The figures in table 1.4 indicate that for finance additional firms the creation of net additional employment of between 5,400 to 9,500. The net costs of the Scheme, over the period July 1993 to the end of 1997, in phase VI were 90 million (excluding DTI administrative costs). This provides a net additional cost-per-job in the range of 9,500 to 16,600. In interpreting this result allowance must be made for the fact that certain phase VI loans that are still live will in due course default. Whilst these loans survive they provide revenue to Government via the premium, but on default the Government must pay the guarantee creating a further cost. The future default of the stock of loan is therefore critical. The peak of the loan profile occurred in 1995/96. The probability of default is highest in the period years following the loan, hence we are close to the high point for defaults. The final outcome may, however, be influenced by several factors including whether the UK enters a period of lower economic growth which would result in a higher default rate for surviving loans Conclusions This evaluation has provided evidence that the SFLGS has provided much needed financial support to a large number of small firms. The majority of this support has been found to be additional to that which would have been available from other sources, supporting the continuing rationale for the Scheme. The economic benefits show that there is a strong case for the SFLGS to continue to play a role, alongside other types of support, in meeting the particular need of SMEs which lack security but nevertheless have sound business propositions. 1.5 Recommendations This evaluation has found no evidence for fundamental change to the Scheme. A number of potential improvements have been identified which are worthy of further consideration and are summarised below: equalising the guarantee level;

9 consideration of the opportunities to develop new lenders to operate the Scheme; developing new material to increase awareness of the Scheme to target groups; introducing a tighter use classification system to govern the use of loans for working capital; investigating the potential and best approach for linking advice and counselling with the loan; and operational and administrative changes to enhance efficient delivery of the Scheme.